Half Full

Cable Stocks were pummeled last week by a furious set of punches, each from a different foe.

The absolute meltdown in cable stocks — five of the largest bottomed out at new 52-week lows on April 26 — was for some industry pundits, a long time in coming.

“Sentiment in cable right now is about the worst I have ever seen,” Pivotal Research Group CEO and senior media & communications analyst Jeff Wlodarczak said, perhaps second only to 2002, when an accounting scandal and weak market tortured the sector.

The sell-off was spurred by several separate events: accelerating video subscriber losses, better than expected growth at OTT services and an ongoing fear that pay TV will just disappear one day.

But was the sell-off more a product of perception than substance? While cable distributors seem to be holding their own financially — revenue and cash flow growth is stable and subscriber declines have been in the 3% range for years — investors believe they see storm clouds on the horizon.

Charter Communications inadvertently touched off the avalanche after it said it lost 122,000 residential video subscribers (about 112,000, though, when gains in business video customers are counted) in Q1, above some analysts’ estimates of 75,000 to 80,000 in losses.

The miss sent Charter stock reeling, with shares falling as much as 16% and hitting a new 52-week low ($250.10 per share) on April 27, sending other stocks southward. Among the stocks that hit new yearly lows for the day were Comcast, Dish Network, Altice USA and Liberty Global. Charter stock closed at $263.33 on April 27, down 12%.

But the sell-off only exacerbated what was a months-long decline for the sector. Prior to April 26, Comcast was already down 14.5%, Charter down 10.6%, Altice USA down 8.3% and Liberty Global down 9.3% since the beginning of the year.

Declines Across the Board

Charter’s subscriber woes followed similar declines at Comcast (down 96,000 video customers in Q1) and AT&T (down 187,000 satellite TV customers in Q1), while OTT services like Netflix and Amazon enjoyed big gains. Netflix added 7.4 million subscribers — about 2 million domestically — in the first quarter. Amazon, which also raised prices for its Amazon Prime free two-day shipping product to $12.99 per month from $10.99, said it had 100 million customers for the service, which offers video as an add-on.

In defending his firm’s plans to merge with Time Warner  AT&T chairman and CEO Randall Stephenson told a federal judge in Washington, D.C., that video will go the way of the landline phone.

In defending his firm’s plans to merge with Time Warner  AT&T chairman and CEO Randall Stephenson told a federal judge in Washington, D.C., that video will go the way of the landline phone.

Wlodarczak said the cable stock declines were the result of a conflagration of issues instead of a single event, starting with worries over the slowdown in relatively low-margin pay TV. Added in were concerns over fixed broadband growth rates and heavy price discounting from AT&T, topped off with concerns that 5G wireless may be a formidable competitor to fixed broadband.

All of this led to thinking that Charter could spend more heavily than expected on its upcoming wireless offering.

Industry leader Comcast has not helped cable’s beleaguered image. Its formal bid to purchase U.K. satellite-TV giant Sky at a multiple of 12 times cash flow has led some to believe the cable giant is overpaying, and is seen as an indication that Comcast has lost faith in its domestic business.

With Charter missing its subscriber targets, the sell-off becomes more understandable. “What you have is a bit of a perfect negative storm in an increasingly skittish broader market,” Wlodarczak said.

And while Wlodarczak sees much of the panic as “laughably overdone,” he doesn’t see it as totally unwarranted. “That does not mean that sentiment — and the stocks — are going to turn around tomorrow,” he said.

In a note to clients, Evercore ISI media analyst Vijay Jayant wrote that the catalyst for the Charter sell-off wasn’t a decline in demand, but rather a software glitch. Charter, in its efforts to integrate billing systems between its legacy systems and those of Time Warner Cable and Bright House Networks, discovered some bad code that had been letting potentially bad credit customers skip having to make a deposit before getting service. Charter said it fixed the glitch in April, but the impact on subscriber growth will likely continue into the second quarter.

Despite the anemic video growth, Jayant said he expects Charter’s video performance to outpace the pay TV industry as a whole, due to the decline in the satellite business and because Charter already has below average video penetration.

Still, disruption by new, more nimble competitors is roiling both sides of the pay TV equation. Programming stocks have taken a beating over the past 12 months, as subscriber rolls dwindle, and customers are opting for skinny bundles and lower-cost OTT packages that don’t include every network.

Increasingly, programmers are looking to make up the difference by bypassing the distributors altogether and offering programming directly to the consumer. The Walt Disney Co. launched its ESPN+ OTT product in April where for $4.99 per month a subscriber gains access to hundreds of off-network games and a library that includes ESPN’s award-winning 30 for 30 documentaries. A Disney-themed entertainment service, to include Star Wars and Marvel content, is slated for 2019.

While programmers gear up for OTT offerings, they are watching their traditional linear TV business dwindle. And it isn’t just the small players that are feeling the pain. Top programmers like ESPN, which just five years ago enjoyed near full-carriage with pay TV distributors, are seeing dramatic declines.

A Shrinking Universe

According to Nielsen Universe estimates, ESPN was available to 98.6 million homes in January 2013 and dropped to 86.8 million homes by January 2018. Other large networks saw similar drops — MTV went from 98.3 million homes in 2013 to 85.6 million homes in 2018; Fox News Channel went from 97.9 million to 88.6 million; CNN went from 99.1 million to 91.4 million; and TNT went from 98.8 million to 90.4 million.

While the decline in pay TV subscribers has been occurring for about a decade, the biggest drop seemed to occur between 2015 and 2018, just as new, lower-priced over-the-top services like Sling TV were beginning to emerge.

Sling TV made its debut in 2015 and has grown to about 2.2 million customers. AT&T’s DirecTV Now over-the-top service, which surfaced in November 2016, already has about 1.5 million customers. Add to that subscribers from Hulu Live, Google’s YouTube TV, Sony PlayStation Vue and others and the numbers can become fairly significant. According to MoffettNathanson, virtual multichannel video programming distributors have grown their ranks by 2.6 million in 2017 to about 4.6 million U.S. residents, some at the expense of traditional providers.

Pay TV subscriber erosion is expected to continue. Sanford Bernstein media analyst Todd Juenger estimates that overall pay TV subscribers will fall from 97 million in 2018 to 82 million by 2025. At the same time, vMVPD subscribers, included in both overall figures, will more than triple from 5 million in 2018 to 18 million by 2025. In other words, vMVPD growth will not be enough to make up for traditional TV losses.

As a result, Juenger estimated that by 2025, network profitability will fall by about 41%.

“The TV network companies are understandably trying to position themselves to capture a greater share of the shrinking pie,” Juenger wrote. “For investors who believe a given network group will fare better (i.e. Fox, or Disney or CBS, etc.), that means the others will be harmed that much worse.”

For cable operators, Juenger predicts total subscribers will fall from 92 million to 64 million and profitability per subscriber will drop from $20 to $11 per month. While some of that will be made up with broadband — which has margins in the 90% range — it could put a strain on that business as well.

At Kagan, an S&P Global Market Intelligence company, programming pundits are considerably less bearish. Kagan research director and senior analyst Derek Baine estimated that subscriber numbers have declined at a 2% annual clip for the past several years.

“What we think is that there will be a thinning of the herd with smaller and midsize networks going off-air, kind of a Darwinian reaction to cord-cutting and cord-shaving,” Baine said.

On a conference call with analysts to discuss its first quarter results, Charter chairman and CEO Tom Rutledge said although the cable operator still believes it can grow video subscribers, “there is very little margin in the video business.”

Meanwhile, top executives from the largest pay TV distributor and the second-largest programmer — AT&T and Time Warner — were telling a federal court judge that no matter how bad you think the pay TV business is, it’s only getting worse.

In the U.S. Court of Appeals for the D.C. Circuit to try to convince a federal judge to approve its $108.7 billion merger with Time Warner Inc. — which the Justice Department is trying to block on anti-competitive grounds — AT&T chairman and CEO Randall Stephenson said under oath that he believes the pay TV business will go the way of the landline phone in the next seven years. And anyone who thinks differently, he said, is just deluding themselves.

“If you’d ask me seven years ago what this world would look like today, I would have missed it so far … the need for people, for content creators, to go through cable companies and satellite companies to get their content to the consumer, that is a thing of the past,” Stephenson said, according to a blog post by BTIG media analyst Richard Greenfield. “They will have direct and immediate access to those consumers.”

Even when Judge Richard Leon, who is presiding over the case, gave him an opening to say the business isn’t as bad as everybody thinks — 90 million customers is still substantial, right? — Stephenson said it was worse.

“It’s declining at a rapid pace,” Stephenson said, according to Greenfield’s blog.

Then why is AT&T even bothering to buy Time Warner? Part of the answer: AT&T Watch, a bundle of non-sports programming (including Time Warner’s Turner networks) that will be offered for free to AT&T Wireless subscribers with unlimited data plans, and for $15 per month for everyone else. AT&T Watch would only be launched if the Time Warner deal is approved.

Wlodarczak agreed that pay TV has to change. For too long, he said, media companies were able to increase fees and ad loads and watch the money roll in. Now that alternatives have emerged in the form of video games, Facebook, Netflix and others, more price-conscious consumers moved away from traditional pay TV.

If content companies go direct and try to make up for lost customers by increasing rates to distributors, though, Wlodarczak believes the distributors will drop the video part of the business and just become data-service providers.

“The irony of all this is with all the content players going direct, plus the launch of new direct platforms, plus cable’s fantastic data architecture you could actually see cable re-emerge as a content aggregator of all these individual ‘direct’ platforms,” he said. “These direct providers could end up giving up some of the economics in order to be carried in these bundles along with cable data.”